Industry implications of scenario analysis requirements
Imtiaz Hussain, Managing Director and Deputy Chief Auditor, BNY Mellon
Below is an insight into what can be expected from Imtiaz’s session at Climate Risk USA 2023.
Disclaimer: The views and opinions expressed in this article are those of the thought leader as an individual and are not attributed to CeFPro or any particular organization.
Can you outline the upcoming Federal Reserve scenario analysis requirement timelines and what this will mean for the industry?
Like many financial regulators across the globe, FRB has launched initiatives to understand the risk of global warming threats to financial risks and resiliency. Such initiatives include climate stress testing for banks. Six U.S. bank holding companies (BHCs) are participating in the Fed pilot Climate Scenario Analysis (CSA) exercise. The participants are expected to submit completed data templates, supporting documentation, and responses to qualitative questions to the Federal Reserve Board by July 31, 2023. The FRB will then review these submissions and hold individual supervisory meetings with participants. The pilot exercise is expected to conclude around the end of 2023.
The FRB anticipates publishing at the conclusion of the exercise thematic insights gained and learnings from the pilot stress tests. The Fed report should assist financial institutions with insights, help identify potential risks, and promote effective risk-management practices.
There is significant value in Central Banks undertaking climate scenario analysis. The exercise aids in understanding financial exposures, understanding any challenges with business models, and enhancing risk management capabilities. Downstream, the learnings can assist Central Banks and financial institutions in supporting strategic decision-making and building capabilities and capacities.
In 2022, the Bank of England (BoE) ran its first climate scenario analysis exercise (known as a Biennial Exploratory Scenario) comprised of the largest banks and insurers in the UK. That exercise informed the BoE that UK banks are making good progress on aspects of climate risk management; however, climate risks are likely to be profitability headwinds if these risks are not effectively managed. The scenario analysis exercise also highlighted that the transition to net zero would expose banks and insurers to certain sectors. One of the consistent themes coming out of the BoE scenario analysis was the lack of data on climate-related factors available to participating banks and insurers.
The scenarios used by BoE are Early Action (EA), meaning ambitious climate policy from the beginning, and Late Action (LA), meaning transition to net zero delayed by a decade. Fed has also joined the Network for Greening the Financial System (NGFS). The NGFS categorizes climate transition scenarios as Orderly, Disorderly, or Hothouse World. Orderly scenarios assume that climate policies are introduced early, whereas disorderly scenarios indicate higher transition risk due to late actions. Finally, Hothouse World assumes business as usual with irreversible consequences.
What are the macro implications and physical risks of climate? How will scenario analysis help institutions mitigate this?
The macro implications of climate include productivity changes from severe heat, capital depreciation from structural changes and supply shock, labor market friction, socio-economic changes from changing consumption patterns, conflicts, and migration, and also impact on international trade, inflation, and interest rates. These macroeconomic implications can already be experienced today and, I believe, will gradually intensify as both acute and chronic changes increase in frequency and intensify weather-related natural disasters.
Climate scenario analysis can help institutions address longer-term business models and other risk impacts and also improve the management of operational risks and resilience. Given the data challenges with climate scenario analysis, a phased approach from qualitative to quantitative scenario analysis could be established depending on jurisdictional nuances, data availability, and capabilities. In the context of people, processes, and systems, it is important for firms to build capacity and technical know-how to enable scenario analysis.
How can firms overcome data limitations of severe stress scenarios?
Climate scenario analysis generally pulls together a vast range of environmental variables such as climate hazard data, emissions data, data on physical assets, transition pathways, and alignment data, to name a few. The long horizon nature of physical scenario analysis also makes the data challenge more complex.
To enable a disciplined climate scenario analysis process that is consistent and repeatable, firms should develop policies and procedures to support the collection, processing, and use of climate data. Good practices involve identifying data needs, understanding the availability of data sources, validating data obtained from external sources and data providers, identifying data gaps, and implementing enterprise-wide system solutions.